Powell Is Fighting for the Minds of the People
(Bloomberg Opinion) -- If all goes according to Federal Reserve Chair Jerome Powell’s baseline forecast, the current surge in U.S. inflation will prove transitory, despite the central bank’s persistent efforts to stimulate growth and reduce unemployment. But what if people stop believing in this benign outlook? This is one of the greatest risks the Fed now faces.
The Fed’s power to manage the economy rests in large part on public confidence. If households and businesses trust officials’ judgment, they’ll expect consumer-price inflation to stay near the central bank’s 2% target in the long run. As a result, they’ll be less likely to demand and offer wage increases, which will help ensure that any surge in inflation proves temporary.
But what if the Fed’s forecast proves wrong, a possibility Powell has acknowledged? A longer-than-expected bout of higher inflation could raise doubts about the central bank’s commitment to its inflation objective. As a result, people’s expectations of future inflation could rise, leading them to respond in ways that would make actual inflation more persistent.
The risk of the second, bad outcome is heightened right now, for several reasons. First, the economic outlook is highly uncertain: Nobody’s sure how the pandemic will evolve or what a recovery from a pandemic should look like. This increases the risk of surprises and of a policy mistake, given how long it takes for changes in monetary policy to affect the economy and inflation.
One important wildcard is the labor market. By some measures, there’s still a lot of room for employment to grow: At 5.2%, the unemployment rate is well above its pre-pandemic level of 3.5%, and the number of people who are employed is still nearly 6 million below where it was in February 2020. But other indicators suggest workers are very hard to find. The most recent Job Opening and Labor Turnover Survey indicated that there were 10.9 million unfilled job openings at the end of July, the most in the history of the survey.
Second, inflation appears likely to climb higher, for longer than anticipated. For example, chip supply shortages, which have constrained auto production and driven a sharp rise in used car prices, seem likely to persist well into 2022. Official measures of housing costs could also surge, following the recent sharp rise in home prices. As a result, I expect Fed officials to raise their inflation projections for 2022 at their policy-making meeting this week.
Third, high inflation will likely push up inflation expectations. This is already evident in one important measure: the New York Federal Reserve’s Survey of Consumer Expectations. As of August, respondents expected inflation to be 5.2% over the next year, and to average 4% over the next three years. These are the highest readings in the history of the survey, which extends back to 2013, and well above the Fed’s long-term target of 2%.
Finally, the Fed’s approach to implementing its long-term monetary framework has increased the risk of a loss of confidence. The central bank has committed not to raise short-term rates until three things have happened: the economy has reached the maximum sustainable level of employment consistent with its inflation objective, inflation has reached 2%, and the Fed expects inflation to remain above 2 percent for some time in the future. This strong commitment to full employment suggests that the Fed will be slow to respond to an increase in inflation that it deems transitory, even if that increase drives up inflation expectations.
Credibility is a powerful tool for keeping inflation in check. If persistently high inflation calls that credibility into question, the Fed’s job will become much more difficult.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Bill Dudley, a Bloomberg Opinion columnist and senior advisor to Bloomberg Economics, is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.
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